I’m the Washington D.C. bureau chief for Forbes and have worked in the bureau for more than two decades. I've spent much of that time reporting about taxes -- tax policy, tax planning, tax shelters and tax evasion. These days, I also edit the personal finance coverage in Forbes magazine and coordinate outside tax, retirement and personal finance contributors to Forbes.com. You can email me at jnovack@forbes.com and follow me on Twitter @janetnovack.

Why Apple's New Bonds Are Less Juicy Than These 5 Junk Bonds

It happens every month or two. I get a slightly nervous call from one of my newer clients. Why, they ask, are we investing in high-yield bonds? Why take the risk?

Why not, they ask, put everything into “investment grade” bonds from the U.S. government? Or perhaps a corporate titan, like AppleApple?

Good old Apple. In April 2013 it issued a record-breaking $17 billion in bonds that were rated AA-plus—as solid as the U.S. Treasury’s. The company reportedly turned away $30 billion in additional orders for its bonds, sending those investors scurrying to the secondary market, where many of them happily paid a premium. Then, this April, it returned to the bond market, issuing another $12 billion worth. The recent bond issue even helped gin up demand for Apple’s common stock, which is up 25 percent in price since late April.

But if you own Apple’s bonds—particularly its 10-year and 30-year bonds in this period of extremely low interest rates—I think you’re holding something significantly less juicy than Standard & Poor’s and Moody’s Investors Service have led you to believe.

The ratings agencies say that your money is almost as safe in those Apple bonds as it would be were it loaned to the U.S. Treasury. But I think you’d make a significantly better return and be just as safe owning other, lesser-known bonds with shorter maturities—including bonds rated double-B or single-B.

Junk, in other words.

To be sure, the problem here is partly one of semantics. We failed, in our post-financial-meltdown reform efforts, to fix the how the two credit ratings giants define what words like “risk” and “investment grade” mean. Both agencies raked in unthinkable profits slapping their triple-A ratings on mortgage-backed bonds that later proved very junky indeed. Yet we never forced them to reform their deeply flawed systems of explaining what’s risky and what isn’t.

If you own Apple’s bonds, you’re probably eager to know which high-yield bonds I think you should trade yours for. I’ve got five names for you, listed in the table below. I don’t consider any of them to be riskier than Apple’s bonds or five-year Treasury debt.

Let’s run some numbers.

First, Apple: I’m a fan of its common stock. I’ve invested over the years. (Though I was perfectly content to sell when the stock began to swoon in 2012, I’ve been a buyer of the shares recently.) And it is in no danger of defaulting on its 10-year and 30-year bonds, which offer skinny yields of 3.1 percent and 4.4 percent, respectively.

Apple has hauled in $176 billion in revenues over the past 12 months. Subtract operating expenses, and the company has garnered $59 billion in cash flow—in the sense of earnings before interest, taxes, depreciation and amortization. Sales and cash flow are currently growing at a healthy 6 to 7 percent rate, so there’s more than enough of the latter to allow Apple to cover the $600 million in debt service it will face on its bonds and other borrowings in the coming 12 months.

In fact, all of 2015 looks fine. Wall Street analysts are projecting that even with the burden of additional debt service, Apple’s earnings will rise almost 10 percent, to roughly $6.90 a share next year.

So, again, there’s no near-term risk of default. And yet, if you buy and hold an Apple 10-year or 30-year bond, you need a dependable projection for what will happen beyond next year. You need to get quite comfortable with the notion that this company will still be hauling in $100 billion to $200 billion a year in sales come 2024 or 2044.

“Apple’s position is unassailable,” you say. I agree, yet we both know that ten years ago, there were two mobile phone makers that totally dominated the market: NokiaNokia and Motorola. Where are they now? Bought by MicrosoftMicrosoft and Google, respectively, only to be stripped of intellectual property and ignominiously broken into pieces. Last month Microsoft announced it would lay off up to 18,000 workers, many of whom came from Nokia.

“Apple makes more than smartphones,” you say. True. Yet looking back 30 years, the dominant personal computer manufacturer was none other than IBM. Big Blue—thanks to its first-mover advantage in the PC market—had an easy time fending off competition from the likes of Atari, Commodore, Sinclair, and Apple. What’s happening now? IBM got out of the PC business long ago—hustling to recreate itself as a services company after nearly going bankrupt in 1992. Only one of the companies that battled IBM in the early days—Apple, ironically—even manufactures personal computers anymore; the others have long since ceased to exist.

Suffice it to say that a lot can happen in tech over the space of a few decades. I scarcely need mention that Apple itself seemed headed for bankruptcy before Steve Jobs regained control of its helm in 1997.

But again, I’ll grant you that Apple is at no foreseeable risk of default. The real risk for Apple’s debentures isn’t the agency rating, it’s the fact that these long-term bond’s prices are too high (i.e., yields too low) in this late-stage bond bull market. History has shown that when interest rates climb, the market doesn’t discriminate between investment grade and junk bonds. In tough market conditions, most bonds with long maturities decline together regardless of their ratings.

I’d rather loan my money at 6 percent-plus rates over the next four years to a company that is also at no real risk of default: Pilgrim’s Pride.

You may not know Pilgrim’s. It’s the second-largest producer of chicken in the world. Based in Greely, Colorado, it has 38,000 employees and hauled in $8.4 billion in sales last year. The $806 million in EBITDA it generated on those sales were more than enough to cover the $87 million it paid out in interest expense to its lenders and bondholders.

Sure, the company’s growing more slowly than Apple, but Pilgrim’s has been in business for six decades. That means it has generations-long relationships with its suppliers and customers. Some 3,900 farms sell chicken to Pilgrim’s, so this is not a company likely to be bullied by its suppliers. Is it innovative? Well, to ward off competition from low-cost competitors in Mexico, it has taken to doing business there itself in a big way. In the chicken business, that’s innovation.

Eating chicken isn’t a passing fad—Southeast Asians domesticated chickens 10,000 years ago, and it’s unlikely we’ll give up eggs or their meat any time soon. But even if Pilgrim’s fails to continue dominating the chicken business over the next three decades, I don’t care. I only need to know the company can pay its debt service until December 2018 — the month when its double-B rated bonds mature.

To me, it seems as reasonable to assume that a chicken producer that has profitably been in business for six decades can keep at it for another four years than it is to suppose that Apple can still be the dominant maker of computers and smartphones over the same period. But S&P and Moody’s, who have never adequately disavowed the term “investment grade” even while asserting elsewhere that their ratings are “not statements of fact or recommendations to purchase, hold, or sell any securities or to make any investment decisions,” give investors the exact opposite message. They say that the technology company seeking to borrow your money for 30 years is as unlikely to default as the U.S. government. They paint the world’s second-largest chicken monger seeking to borrow your money for four years as the subprime bet.

It’s a financial obscurity—the kind that you can profit from if you’re a retail investor willing to think for himself.

Right now Pilgrim’s Pride December 2018 bonds are trading at around $106—$6 more than par—and yielding 6.3 percent. That’s the kind of return that many stock market investors would pleased to average over the next three or four years.

The Pilgrim bonds are callable starting this December. I think it’s unlikely they’ll be called, but nonetheless, an investor who buys the Pilgrim bonds today would realize a yield of only 2.48 percent. That’s not a loss. In fact, that’s a 200-basis-point premium to the return that the same investor would have earned owning a five-year Treasury.

Ok, so you’re not a fan of either white or dark meat. How about oil?

Energy XXI is an offshore driller that specializes in the shallow-water “shelf” of the Gulf of Mexico. Its bonds—rated at B and maturing in December 2017—are yielding a whopping 6.77 percent at present prices. Energy XXI has a simple and effective strategy — buy the rights to the oil fields once exploited by oil majors like Exxon Mobil, and use modern technology and engineering know-how to pull out the reserves that the oil majors don’t want to spend their time on.

The big boys need big “plays,” so don’t want to waste time wringing their hands about how to suck up the last drops out of older wells. They would rather move further offshore, further into deeper water, and drill into the really huge, untapped reservoirs there. This love ‘em and leave ‘em strategy on the part of the majors has enabled Energy XXI to become the largest producer of oil on the shelf of the Gulf of Mexico and to generate between $200 million and $500 million of operating income over the last three years. Its interest expenses have stayed flat over this time at around $100 million, which means they have been able to comfortably pay financing costs on its bonds.

As long as oil demand remains strong — and with improving economic and employment numbers starting to come out, that is looking pretty likely — Energy XXI should easily continue to generate enough profits to pay its debts until December 2017, when its single-B rated bonds mature. As with Pilgrim’s Pride, the choice to invest in Energy XXI’s bonds over those of tech darling Apple comes down to two fundamental points about real investment risk.

First, we know that both chicken and oil are products that consumers in the U.S. and everywhere else will demand for decades to come. The same thing cannot be said for Apple’s iPhones and iPads.

Second, we know that interest rates are at historic lows right now, and they seem likely to remain low for a while. But when rates eventually start to rise, long-term bonds with very low yields will plummet in price. By buying and planning to hold Apple’s low-yield, long-term bonds to maturity, we are stepping up to the plate to voluntarily accept a capital loss when we swap out our low-yield bonds for higher-yield ones in the future. It’s hard to imagine anything riskier than volunteering to take a loss.

Considering these points, it’s clear to me that long-maturity Apple bonds not an entirely risk-free investment, no matter what the rating agencies say. Some Apple bondholders got a little taste of what the downside could feel like when the company’s bonds suffered through a correction last summer. To be sure, as with a stock portfolio, a bond portfolio should be well diversified by limiting each holding to no more than 5 percent of the entire portfolio. History shows that diversification will give you better protection and returns than just buying large positions in marquee names.

In addition to Pilgrims’ Pride and Energy XXI, I’ve got my eye on a few other issues that would be great additions to a diversified bond portfolio. In the table higher up, you’ll find my favorite high-yield bonds right now, alongside numbers for very low-yielding bonds issued by Apple and other big companies that the credit agencies insist are virtually risk-free. Which would you rather own?

Post Your Comment

Post Your Reply

Forbes writers have the ability to call out member comments they find particularly interesting. Called-out comments are highlighted across the Forbes network. You'll be notified if your comment is called out.